Momentum Strategy: Skip Stocks, Go for Sectors

You’ve no doubt been warned more than once that chasing last year’s winners is a fool’s game that increases your trading costs, tax liability, and investment risk.

That’s especially true if you are constantly moving in and out of individual securities, which is the classic momentum strategy. Yet a decent body of research suggests that entire asset classes that shine in one year have a better-than-average chance of outperforming in the next.

“Momentum is persistent, pervasive, and well documented in virtually every investment and in every country,” says Gregg Fisher, chief investment officer with the asset-management firm Gerstein Fisher.

So how do you take advantage of momentum wisely? As with many things in life, moderation is key.

Lessen the bounce

Sam Stovall, chief equity strategist with S&P Capital IQ, points out that any added gains from buying what’s been going up “don’t come free.” History shows that momentum investors have to assume greater fluctuations in their returns.

But there’s a neat twist to the numbers. Researchers at the asset-management firm Leuthold Group divvied up the investment universe into seven major asset classes: blue-chip U.S. stocks, small-company shares, foreign equities, government bonds, commodities, gold, and real estate investment trusts.

Over the past four decades, a portfolio entirely made up of the prior year’s absolute top asset class beat the S&P 500 by more than three percentage points a year, but it was also two-thirds choppier.

A “bridesmaid” portfolio composed of the previous year’s second-highest performer, however, was only slightly more volatile than the index, and it returned five percentage points more. (For the record, last year’s runner-up asset class was blue-chip U.S. stocks. Small U.S. stocks were the absolute winner.)

Be only a little greedy

Of course, no sane investor would keep such an undiversified portfolio; there are years it would kill you.

In 1997, for instance, you would have lost more than 14% holding a basket of commodities while the S&P 500 returned more than 33%. And turning over sizable chunks of your holdings would indeed cost you in fees and taxes, eating into your gains. So momentum strategies should be applied with a good bit of caution.

Fisher suggests that you think about leaning slightly toward what’s hot — say, by moving up to 10% of your portfolio to a momentum-driven approach — rather than committing huge chunks of your capital.

“Our view is that investors are well served by tilting toward momentum,” Fisher says. “But they’re even better served by doing so in the context of a well-diversified portfolio.”